Value Funds Are Suddenly the Place to Be

It's all coming together for value ... finally

These days, it’s hip to be square. After lagging the growth style through most of 2012, value stocks have re-emerged as a source of outperformance. Investors who felt the pain as their value funds gained ground but didn’t fully participate in the rally are finally seeing their patience pay off.

The numbers tell the story.

On Sept. 19, 2012, iShares Russell 1000 Growth Index Fund (NYSE:IWF) had a year-to-date return of 18.20%, comfortably ahead of the 16.42% gain for the iShares Russell 1000 Value Index Fund (NYSE:IWD). Since that date, IWD has outpaced IWF by more than 6 percentage points (8.78% to 2.58%). It’s a big advantage for value in such a short period, especially considering that the growth ETF has outpaced its value counterpart by more than 3 percentage points since the funds’ inception in May 2000. Since that time, IWF has generated a 4.86% average annual return versus 1.64% for IWD.

So, why the sudden run of outperformance for value stocks?

First, of course, is the impact of Apple (NASDAQ:AAPL) on the growth index. The Sept. 19 date mentioned above, while seemingly arbitrary, is the date on which Apple hit its closing high of $702.10. At its peak, Apple made up more than 8% of the growth ETF’s portfolio, and still remains its top holding. Just as this helped lift growth against value in the first nine months of 2012, so too has it played in IWD’s favor since AAPL began its trek down into the 400s.

The second key factor is the higher weighting of financials in the value indices. Financials make up 27.9% of the value ETF, compared to just 7.3% of the growth fund. And since the November low, financials have blown the doors off of the rest of the market: The Financial Select Sector SPDR (NYSE:XLF) has surged 17.7%, way ahead of the 12.9% return of SPDR S&P 500 ETF (NYSE:SPY).

There’s more to the story than just Apple and financials, however.

In general, value stocks simply offer investors a better deal right now. According to data compiled by Standard & Poor’s, the value stocks in the S&P 500 Index are estimated to report EPS growth of 17.3% in 2013, compared with 12.1% for growth stocks. The advantage is smaller in the MidCap 400 Index (18.7% vs. 18%) but much larger in the SmallCap 600 (44% versus 19.4%).*

Despite this advantage, value stocks have lower P/E’s than growth stocks across the board:

INDEX

LARGE CAPS

MID CAPS

SMALL CAPS

S&P Citigroup Growth Indices

14.7

18.3

18.7

S&P Citigroup Value Indices

12.3

15.2

15.7

Not least, value holds its traditional yield advantage over growth: IWD currently offers a yields of 2.1%, beating the 1.5% for IWF.

But does that mean it’s time to hop on the value train right now?

That’s an iffy proposition, since further outperformance for value stocks depends on a continuation of the outsize gains in financials, where the rally is getting a little long in the tooth. Valuations in the group aren’t particularly demanding on a forward basis, but the sector is ripe for profit-taking if any external issues — such as Europe, sequestration, etc. — crop up in the weeks and months ahead. If that occurs, value stocks could surprise those who expect the sector to hold up better than growth when the market is falling.

For the time being, however, value investors are finally enjoying a long-awaited stretch of outperformance.

* All numbers are as of Jan. 24.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.